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9.28.2009

Macro Economics #3 - Keynesian stimulus and the Recession

Whenever we have a recession and the government thinks that it is because demand is falling; our government thinks that by using expansionary monetary and fiscal policy it can jolt the economy back to life. This is dangerous if they assume this is a cure-all elixir and start to abuse it.

First, let's discuss how Keynesian stimulus works. Why do demand side recessions happen? It is usually because we overbuild and over-expand our production facility using debt and when the asset appreciation starts to slow down, the profit is unable to keep up with the interest payment on the debt used to expand the facility. When this happens factories and retailers starts to go out of business and rising unemployment causes the demand to fall even further and make the problem worse.

Governments think that Keynes was very smart because he says that when this happens all the government needs to do is simply spend a lot of money by borrowing, and also lower the interest rate by supplying more cash to the market. Then the consumer will start to borrow and spend again, demand will pick up and economy will come back to life. This worked in 2003 but what was the result? We got the biggest housing bubble in history! When the interest rate is lowered, and the government starts to spend money to save people's job, yes, those who got saved and those who still have a job with a smaller house or without a house will upgrade their housing because when mortgages are cheaper they can afford bigger loan amount, i.e. their purchse POWER goes up. Housing bubbles will also produce profits for other industries; it creates construction jobs, and other jobs that supply things like furniture and electronic that people usually also upgrade with their new house. This higher profit leads to increased income and further increases the loan amount one can afford. The virtuous cycle will successfully push the demand back up and the economy is SAVED.

Will it work this time when we already had a housing bubble and when everyone's credit card is already maxed out? My question to the government and Keynesian economists is this: what asset will people now buy when credit card interest rates are around 30% if they already knew it was a bubble when mortgage interest rates were at 5%? Will lowering it to 5% again successfully boost the house market back to the bubble level? Will people be as stupid again?

If we can't find another driver for jobs what will happen if government keeps borrowing money by printing? Remember, Quantitative Easing means government borrow money from the market, while Fed prints money to buy the debt back from the market. Now, we are going to touch the core topic of this analysis: Inflation VS Deflation.

First, when government prints people will start to fear inflation is coming because the money is so cheap. Businesses will expect the economy to come back to life and those who still manage money, like fund manager, will go in and push commodity prices up. We will see commodity prices to go up as a result (inflation on commodity front). The key question is will this introduce inflation on FINISHED GOODS? I doubt it because consumer debt is maxed out. When consumer debt is maxed out, the retailer and producer has little power to increase price. The demand is shrinking, so increased price will make smart consumer find the more efficient stores that can keep price the same and still make some money. When the economy is booming even most efficient retailer can't supply every demand in the country so inefficient stores can profit as well. But when the demand is falling fast, more and more businesses will be driven out by more competitive retailers.

So what can the retailer do to keep profit? They need to be more efficient, and that means they need to cut wasting and fire non-competitive workers. This will make the problem worse for non-efficient retailers. Eventually, big department stores like Macy's will go down first because their cost of operation is too high. When a major department store goes down, so goes the shopping center. A major bankruptcy will take down many other firms with it and the liquidation sale will cause the commodity price and finished goods to crash include housing. Then the surviving firms may or may not raise price because there is less competition but at this time people also will have less money to spend because of higher umemployment. Please remember this is a long process, it takes months to play out and you will still feel deflation at this point because of liquidation crash on consumer goods.

What if the government stops printing and borrowing at this point? We will get super great depression! But what if they keep printing? The entire cycle will repeat but there will be even higher inflation on commodities and even though there are less businesses around to fail, eventually we will cross the point when every business and job is saved by government which will result in Zimbabwe style hyper-inflation.

Another key point to remember is that Japan and US are different because Japan is an exporting country while the US is an importing country. My past analysis is based on an importing country because our business profit is largely based on importing costs. The case will be a bit different in Japan case because they are more exporting oriented. I will analyze Japan in my next post.

So will government keep printing? I think they will because hope is always the greatest when you try something for the first time. When this same trick fails again and again, eventually political pressure will force the governement to try something different. This is why I am expecting super depression instead of hyper-inflation because I believe Americans are smarter than Zimbabweans and won’t let their country create hyper-inflation which is far worse than a super depression. The American will will finally force the bad debt to be purged from the system.

Of course another risk is that America goes the same path as Weimer Germany where we elect a fascist president and wage war against other country to rob their resources. If that happens, then it is time for the third world war. I certainly hope that won't happen.